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The Fourth Industrial Revolution: Block-Chain and Smart-Contracts

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About The Author

Chi Nguyen (Guest Contributor)

Chi is a Politics graduate from the University of Kent who hopes to pursue a career as a solicitor. Outside the law, he enjoys football and boxing.

At its core, law is information based and we are in the middle of an information revolution.

Richard Susskind

The rapid emergence of new disruptive technologies such as the ‘block-chain’ and ‘smart-contracts’ symbolises the gradual manifestation of an information revolution. The development of these new technologies will profoundly shift the way businesses operate internally and externally. Such technological changes mark the advent of a ‘Fourth Industrial Revolution’, argues Klaus Schwab, the founder of Davos.

Within the legal sector, the fourth industrial revolution will empower lawyers who can successfully embrace this new wave of technology. However, those who remain stagnant and unwilling to readjust their position will discover their traditional roles as intermediaries obsolete. As this article will examine, the emergence of disruptive technologies presents a unique opportunity for lawyers to reposition themselves as trusted strategic legal advisers to clients navigating the countless regulatory and logistical webs, surrounding the commercial application of these disruptive technologies.

What is a Block-Chain?

A block-chain is simply a technology which enables the movement of digital assets – for example, digital currencies, contracts, certificates, statements, proof of financial transactions – from one source to another using a decentralised distributed ledger system.

Unlike a traditional ledger – a principal computer file for recording and totalling economic transactions administered by a central entity (i.e. bank or government) and audited by trusted intermediaries (i.e. accounting or law firms) -  a distributed ledger like a block-chain, removes the need for centralised entities to supervise transactions in the system. The need for central administrators to authenticate and audit transactions is eliminated, since all participating members can view every transaction to collectively decide on its validity; all transactions are transparent and can be seen by all the participants.

‘Bitcoin’, the electronic payment system, provides an example of block-chain technology in action. Block-chain is the underlying technology upon which Bitcoin transactions are executed. The decentralised system allows users to trade peer-to-peer, with all transactions verified, recorded and executed on the block-chain’s distributed ledger system.                                                                                                         

The block-chain’s ability to efficiently transport digital data is just as sophisticated as its ability to protect such data. It utilises ‘cryptographic hash function’ and ‘time-stamping’ to ensure all the data within its network is immutable to external threats.

The cryptographic hash function means that, any time a transaction happens, the block of data which is created to represent the transaction is encrypted cryptographically using hash codes to safe-guard the data in the block. Successive transactions will create additional blocks which are cryptographically chained to the previous block. This creates more hash codes every time, therefore anyone attempting to hack a particular block will have to also hack all the encrypted blocks preceding it.   

Each block is also time-stamped, meaning every transaction or block will have a corresponding digital record created in real-time. This digital recording mechanism leaves an audit trail verifying the time and order of all transactions involved in that particular block-chain. Time-stamping offers several security benefits: a) it prevents blocks containing sensitive data of transactions being tampered retrospectively, as security increases with each transaction; b) it verifies the time and order of each block, allowing participants to identify dubious transaction attempts; c) in the case of dubious attempts, it rejects any transactions which violate the pre-programmed rules of the network (i.e. an incorrect payment).

Lastly, in virtue of its distributed ledger system, to infiltrate a block-chain effectively requires a hacker that is able to simultaneously hack all the sites on the network at the same time – a difficult task.

What Does Block-Chain have to do with Commercial Law?

In the near future, block-chain technology will be used by many industries in which law firms provide legal services to: for example, banking and finance, insurance, and private equity and investment management. As currently, the centralised ledger system adopted by many of these sectors over-complicates the movement of important digital data. This complexity creates more risk, delays transaction times, and increases administrative costs.

Today, clients of law firms are demanding ‘more-for-less’, therefore, one way to meet client expectations is to untangle the complexities associated with a traditional ledger system. Using block-chain technology will allow firms to streamline the delivery of their services, reduce transaction times, reduce risk of fraudulent attacks, and cut costs by operating more efficiently. Innovative law firms will see an opportunity to reposition themselves as strategic legal advisors. This will allow law firms to generate revenue from any uptick in commercial activity from clients who wish to adopt these new disruptive technologies.

Insurance

In 2016 a group of industry leaders in the insurance market – Aegon, Allianz, Swiss Re, Munich Re, Zurich – created the block-chain insurance initiative ‘B3I’ to explore the potential of distributed ledger technology in order to better service clients through faster, more convenient and secure means. Implementing block-chain technology means insurers will be able to simplify the claims process and remove friction in the underwriting and handling of claims. Block-chain also offers a huge potential for enabling digital contracts and transactions within the network to be executed amongst all participants in a safe, transparent and auditable way.

However, in creating a consistent self-executing contract environment, the block-chain threatens the traditional role of law firms/ lawyers as trusted intermediaries. Certain low-value legal task such as the execution of contracts will be automated by self-executing smart-contracts and audited by all the participants in the network, thereby removing the need for lawyers. The legal needs of insurers who intend to use block-chain technology will change, and law firms will have to accept this reality and adapt accordingly.

Private Equity and Fund Management

Northern Trust, a private equity firm, began work with IBM’s Hyperledger block-chain technology this year to explore the use of block-chain technology within a private equity fund. The IBM ‘Hyperledger Project’ is “an open source collaborative effort created to advance cross industry block-chain technologies”. The move by Northern Trust is designed to create a system which delivers more efficient sharing and communication of the private equity fund’s contractual, regulatory and financial information. The objective is to therefore produce a transparent and low-cost method of sharing legal and financial data, and to execute business decisions endogenously in the block-chain, without having to funnel all the data and communication through an intermediary such as a law firm. As expressed by Peter Cherewich, the president of corporate and institutional services at Northern Trust”: “current legal and administrative processes that support private equity are time consuming and expensive”.            

The changing legal needs of stake-holders within private equity funds means that law firms will have to readjust their stance in the industry. Instead of straining to keep hold of low value matters, such as overseeing the day to day administration of legal documentation, firms should accept the reality that improving efficiency by incorporating disruptive technologies is  something clients now demand. Tech-savvy lawyers and firms who understand the legal implications of what these new technologies mean for clients operating in a legal and regulation bound environment, will be able to use their knowledge to advise clients on how to best achieve their commercial objectives; thus, still playing a key role in the legal needs of the client.

Where Do Smart-Contracts Fit into the Block-Chain Technology?

According to Nick Szabo, a computer scientist widely credited for inventing the idea of a smart contract, a smart-contract contains four key characteristics: a) it exist in digital form through code, data and programs; b) it is embedded, meaning it contains contractual clauses which are encoded; c) the performance of the contract is mediated by technology which utilises a pre-programmed rule-based operation; and d) it is irrevocable – once a rule has been executed the outcome cannot be reversed, unless such outcome is derived from a transaction that infringes on the pre-programmed rules.

Essentially, a smart-contract is a computer program that enables the facilitation, execution and enforcement of a set of rules for negotiating the terms of a contract. It automates the validity of the contract and self-executes agreed terms and conditions, using block-chain technology. Unlike traditional physical contracts which require a huge amount of printed documents and rely heavily on third parties to be legally binding, smart-contracts remove the intermediary to create a legally binding contract which allows parties to trade and do business peer-to-peer.

The concept of a smart-contract turned into a reality after the invention of Bitcoin, as the underlying block-chain technology which functioned as the engine for Bitcoin’s peer-to-peer service, also contained within it the mechanism of a self-executing program code, which allowed transactions to be verified on the block-chain without the need for an intermediary. These small codes represented an early variant of a smart-contract, as the codes performed to execute agreed outcomes when triggered by agreed pre-programmed rules – just like a traditional contract, which only produces an agreed outcome when all prior conditions outlined in the provisions of the contract are met. The key difference between a smart-contract and a traditional paper contract, is that the former is self-executing and eliminates the need for an intermediary, while the latter requires an intermediary (i.e. lawyers) to authenticate the arrangements and transactions associated with the contract.

                                                                                

The Legal Implications of Implementing Smart-Contracts

For future lawyers, understanding the legal implications for clients using smart-contracts to achieve their commercial objectives will be key to remaining competitive in the changing legal landscape.

It is naïve to assume that in virtue of its name - which includes the term ‘contract’; that a smart-contract is legally binding as a matter of law. In reality the legal weight of a smart-contract is heavily dependent on the model that is used, the jurisdictional environment in which it intends to operate, and certainty as to what constitutes the contractual terms. For example, there is the possibility that deploying a smart-contract model which is fully encoded (contract fully expressed in code), will allow businesses to replace complex natural language contracts. At the other end of the spectrum, it may be possible to have a model which only digitises the performance of business processes (i.e. payments), meanwhile still using a natural language contract framework.

However, both models present legal challenges which must be considered by lawyers and businesses. The main legal issue concerning the formation of a fully encoded model, is that it is not realistic to encode an entire contract, as the current state of technology is not sophisticated enough to process ambiguous legal phrases which may only be determined by legal analysis. Phrases such as “reasonable endeavours” and “reasonable steps”, are formulations which involve a judgement that depends on legal analysis. This is a technical problem which arises when attempting to code the entirety of a complex natural language contract.                                

For a model which only digitises business processes, the issue of certainty as to what constitutes contractual terms emerges. Smart-contracts which digitises specific processes but do not accommodate or include key contractual terms (express or implied), may be regarded as to vague to satisfy the requirements of a legally binding contract in court.  

Sean Murphy, Global head of Blockchain and Distributed Ledgers at Norton Rose Fulbright, outlines the possibility for a ‘split-contract’ model which could resolve the legal issues presented in the previous models. A split-contract model permits non-human performances to be processed in code, meanwhile human obligations ascertaining to legal provisions for example, are written into natural language; to remedy the possibility of ambiguity. This model offers a smart-contract framework which allows both natural language clauses and business logic to operate in a complementary manner, to form a cohesive model which is legally binding. The closest example of a split-model contract is perhaps the ‘Ricardian Contract Model’, which places the defining elements of a legal agreement in a format that can be easily be extracted for computational purposes, and readable as an ordinal prose document such that lawyers and contracting parties may read the essentials of the contract.

Why Smart-Contracts Matter for Law Firms

Businesses attempting to deploy smart-contracts will have to be very aware of the potential legal problems involved. As described in the previous section, choosing an incorrect model could result in the risk of a court punishing the business if the model is not in fact legally binding. Although the role of law firms as an intermediary used to validate the formation of contracts may be usurped by self-executing and self-authenticating smart-contracts, the opportunities for law firms which recognises the prospect of helping businesses understand the risk of implementing these new technologies, will be great. Innovative law firms can operate as high value strategic advisors, who will be able to offer the appropriate regulatory compliance investigation into the smart-contract model intended for deployment. Assessing whether or they such model would be legally binding in the jurisdiction they intend to operate and whether or not it is legally enforceable.

Conclusion

Admittedly, this article only scratches the surface of scale of block-chain and smart-contract technology. However, it is intended to provoke thought and to encourage aspiring lawyers to consider the commercial implications of disruptive technology on the legal sector. The emergence of disruptive technology is a reality which law firms and lawyers must learn to grapple with. As competition gets tougher and the legal landscape continues to shift, tomorrow’s lawyers must be open-minded and entrepreneurial in adapting to these changes.

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